en years ago, Congress enacted a system that forces taxpayers to pay more in interest on their debts to the Internal Revenue Service than the IRS pays on its debts to taxpayers. This is true even when a particular taxpayer and the government simultaneously are indebted to each other. Recognizing the incongruity of these rules, Congress directed Treasury and the IRS to rectify potential inequities with appropriate netting procedures. In the intervening decade, no comprehensive netting policy has emerged.

Background

Starting with the Tax Reform Act of 1986, Congress began charging higher interest rates on underpayments than overpayments. The one percentage point difference created in 1986 grew to 4.5% in 1994, when the Uruguay Round Agreements Act expanded the differential between large corporate underpayments and certain corporate overpayments.

The most dramatic differential, and perhaps the least justified, results from section 6621(c) of the Internal Revenue Code, which increases the interest rate by 2% on underpayments by C corporations that exceed $100,000 for a given taxable period. Hot interest, as it is known, starts accruing if the underpayment remains unpaid 30 days after the date a notice of deficiency is sent; the date a notice of proposed deficiency (30-day letter) is sent; or, if deficiency procedures do not apply, the date the IRS notifies the taxpayer that the tax has been assessed. This means that if a 30-day letter is issued and the taxpayer files a protest to take the unagreed issues to Appeals, hot interest will start accruing 30 days after the proposed deficiency letter is sent.

This large differential is hard to defend on policy grounds. Large corporations with known tax disagreements are not worse credit risks than small taxpayers or taxpayers whose debts to the IRS are yet to be discovered. Penalizing taxpayers for taking disputes to Appeals is wrong. Our system is too complex and the authority of examining agents too limited to allow prompt settlement of reasonable disagreements.

In theory, interest under the Internal Revenue Code (1) is intended to compensate the government or the taxpayer for the use or forbearance of money and (2) applies only if amounts are both due and unpaid. (See, e.g., I.R.C. section 6601(a); and Rev. Proc. 60-17, 1960-2 C.B. 942.)

Whenever Congress increased the interest rate differential, it concomitantly has prescribed that the Service should implement the most comprehensive procedures "consistent with sound administrative practice" to allow the netting of overpayments against underpayments. [See I.R.S. Notice 96-18, 1996-1 C.B. 370 and accompanying legislative history citations; and H.R. Rep. No. 506, 103d Cong., 2d Sess. 50 (1996)("Congress has never adopted differential interest rates, or increased the amount of such differential, without at the same time also encouraging the IRS to implement comprehensive interest netting procedures. The Committee is concerned that the IRS has failed to implement comprehensive interest netting procedures...")]

The Taxpayer Bill of Rights 2 (Pub. L. No. 104-168, 110 Stat. 1453, 1473 [July 30, 1996]) required the Secretary of the Treasury to perform a study of the netting of interest on federal tax overpayments and underpayments.

In a September 26, 1996, letter to Treasury Secretary Rubin, House Ways and Means Committee Chairman Bill Archer, R-Texas, observes: "In my view, Congress has given Treasury and the IRS both a clear mandate and clear authority to implement comprehensive procedures to net underpayments and overpayments before applying differential interest rates. . . . interest netting is a problem that Congress has long expected would be resolved administratively and I certainly hope that Treasury will reexamine its position on this issue."

On April 14 of this year, the Clinton Administration included an interest netting provision in its tax simplification package. The President’s proposal would allow global interest netting (discussed below) for the period that an underpayment and overpayment overlap. The provision is expected to cost $134 million over five years.

The Problem

The most egregious applications of the discrepancy in interest rates occur when the taxpayer and government have offsetting claims. In some cases, a taxpayer can find itself paying a 4.5% interest charge when no net principal is changing hands. Stated differently, assume the interest rate on refunds was 6% and the hot interest rate was 10.5%. Further, assume a taxpayer satisfied a $10 million claim by the IRS and paid hot interest for a given period. If subsequently the taxpayer was owed a refund of $17.5 million for the same period, it would receive interest equal to the amount it paid on its $10 million deficiency. In effect, the government would have gotten a $7.5 million interest-free loan from the taxpayer.

On April 18, 1997, the Treasury reported to Congress on the "Netting of Interest on Tax Overpayments and Underpayments." Treasury identified three forms of interest netting:

(1) annual interest netting (from Rev. Proc. 94-60, 1994-2 C.B. 774 and section 6621 of the Code; the Service considers increases and decreases in taxpayer liabilities within a single tax year before applying the statutory interest rules);

(2) offsetting (netting overpayments against underpayments when both are unpaid and outstanding, even if they arise in different tax years or involve different types of tax); and

(3) global interest netting (i.e., netting interest when either an overpayment or unpaid deficiency in one tax year overlaps with taxpayer or government payments already executed in different tax years).

Although the report acknowledges that statutory authority exists for offsetting and annual netting -- even though annual netting is based on a broad administrative interpretation of section 6621 -- the report maintains that "global netting is probably not authorized at all under current law." (See generally I.R.S. Notice 96-18, 1996-1 C.B. 370.)

Referring to what it perceives as inconsistent policy preferences on the part of Congress, the report recommends that Congress clarify its goals and objectives regarding comprehensive interest netting. At the same time, the report emphasizes that global netting may have a significant adverse impact on IRS resources. Consequently, the study proposes that limitations on the scope and extent of global netting may minimize any potential adverse effect on the Service and make it possible for global netting to occur at little additional cost.

In Northern States Power Co. v. United States, the Eighth Circuit concluded the IRS is not required to perform global interest netting computations. The case involved a dispute over the calculation of interest due on a refund. In 1990, Northern States Power Company (NSP) paid the IRS over $23 million, plus interest, as a result of an audit. Subsequently, NSP filed amended returns, asserting previously unclaimed tax credits for years that were also the subject of the earlier audit. Ultimately, the IRS and NSP determined that the agreed-upon deficiencies for three tax years were "smaller than was thought when NSP paid its $23 million deficiency." NSP actually overpaid its taxes. Thus, the government owed NSP a refund, plus interest. However, the IRS and NSP could not agree on how to calculate the interest component of the government’s debt.

Holding that Section 6402(a) of the Code confers only general authority upon the IRS to credit an overpayment against any liability, the Court ruled that if a taxpayer’s liability is fully paid, no "outstanding liability" exists against which the IRS can net a subsequently determined overpayment. Nevertheless, the Eighth Circuit did confirm that the IRS has discretion to credit overpayments against underpayments.

In comments on the Taxpayer Advocate’s first annual report to the House Ways and Means Subcommittee on Oversights and Taxpayer Advocate, the Tax Division of the American Institute of Certified Public Accountants (AICPA) cites the Northern States Power case and remarks that netting outstanding payments against outstanding liabilities "is unfair to taxpayers that promptly pay contested amounts of tax." The AICPA further notes that if NSP had delayed paying the alleged deficiencies, it may have saved $460,000 in additional interest.

Possible Solutions

In the wake of the Treasury report and the Eighth Circuit’s decision in Northern States Power, taxpayers must deal with the Service on interest netting issues without any authoritative guidelines, policies, practices, or procedures. Thus, the Service authorizes netting, if it performs it at all, only on an ad hoc basis.

Does this imply taxpayers should surrender to the vagaries of the audit cycle and the caprice of individual IRS agents? Absolutely not! President Clinton’s proposal to allow global interest netting provides authoritative, high-level support for the view that the government should be compensated with interest only for the time the taxpayer has the use of tax money to which the government is entitled. Now, it is up to Congress to adopt this proposal. Further, even where true tax liabilities are blurred by loss or credit carryback and carryforward provisions and multiple tax years or examination periods, proactive discussion of interest issues early in the audit process should enable taxpayers to prevent interest netting from obfuscating settlement negotiations. Otherwise, inconsistency and unpredictability can taint the settlement process, infecting negotiations with suspicion and hostility. As articulated in the March 12 comments of the AICPA:

The Service has used the netting issue as a bargaining chip in negotiations to extract concessions from taxpayers on issues under examination. This inappropriately distances negotiations from the merits of the underlying issues. It also has the inappropriate effect of using netting (or the absence of netting) as a tool to raise revenue, rather than as a means to compensate for the use of money.

Even if interest netting cannot offer any relief, Coordinated Examination Program (CEP) taxpayers may avoid hot interest on underpayments by following Revenue Procedure 96-9, I.R.B. 1996-2 (Dec. 15, 1995). This revenue procedure, known as Appeals Early Referral, allows CEP taxpayers whose returns are being audited to request that developed, unagreed issues be transferred to Appeals while other issues continue to be developed in Examination. Since no 30-day letter is issued at this point, hot interest does not start accruing while the issue is being considered in Appeals.

Hot interest also can be avoided through the use of Delegation Order 236, Settlement Authority for Examination Managers. This delegation order allows IRS Examination personnel to settle rollover and recurring issues for CEP taxpayers in a manner consistent with an Appeals settlement in prior or subsequent years. If a settlement can be reached through this procedure, a 30-day letter is not issued and hot interest does not start accruing.

In addition to avoiding hot interest, ensuring that interest -- both interest paid to the IRS and interest due the taxpayer -- is calculated in the most advantageous way for the taxpayer requires vigilance on the part of taxpayers. Whenever a taxpayer owes additional tax or is entitled to a refund, the way credits are applied and the starting dates for computing interest can have a dramatic impact on the ultimate interest -- it is much more than doing the arithmetic correctly. Most of the complex computations of interest are done manually by IRS personnel and are therefore subject to errors. And, as discussed above, netting can reduce interest dramatically, but usually this does not happen without some effort on the part of the taxpayer. Taxpayers and their representatives must be aware of the rules surrounding the computation of interest because the differences can be significant and large IRS errors do happen.

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